Thursday, June 7, 2012

Brussel's latest mistake

Right now, the debate raging in Europe is how to rescue the insolvent Spanish banking system, which is being bled dry by depositor outflows. Spain has asked the EU to recapitalize its banks (to enable the ECB to keep lending against the run). There is debate concerning the need for a eurozone deposit guarantee to restore confidence and end the runs on the peripheral banks. Depositors in the peripheral countries face the risk of bank failure as well as the risk of a forced redenomination into domestic currency.

Because banks are highly levered, inherently illiquid, and analytically opaque, depositor confidence is maintained by the expectation of both a lender of last resort as well as a state rescue authority. Such mechanisms are the reason why banks never default on their deposits and are instead rescued (bailed out). Throughout the entire financial crisis of 2007-12, no eurozone bank, no matter how tiny, has defaulted upon its deposits.

The state mechanisms that backstop depositor confidence depend upon the willingness and the ability of the state to rescue banks. This has now been called into question in the eurozone because a number of states lack the resources required to maintain systemic solvency, which the ECB requires as a precondition for lending. That problem is most acute in Spain at the moment. Something will have to be worked out quickly to recapitalize the Spanish system, which requires at least EUR 40-50 billion.

Governments rarely publish blanket deposit guarantees, but they are understood to exist implicitly. Because regulators want investors to provide a degree of market discipline, such as credit ratings and other measures of solvency, they create sufficient constructive ambiguity around bailouts for markets to punish weaker banks. This requires a dance between depositor discipline, on the one hand, and market confidence on the other. No regulator can realistically expect Mrs. Gonzalez (or Papadakis) to add bank analysis to her other daily responsibilities.

Because governments stand behind their banks, when banks fail they are rescued at government expense. Generally (always) all bank senior creditors are protected with only holders of subordinated debt and other capital instruments at risk. Because banks are never “wound up” the way that failed grocery stores are, there is no way to impose losses on senior creditors such as bondholders; there is no liquidation. Therefore, the government must bail out the bank’s bondholders, who are generally large institutional investors. Taxpayer money is being spent so that these investors can walk away whole. This is politically unpopular.

Because Mom and Pop do not want to pay for bank bailouts, there is a frequent call for resolutions to impose costs on bondholders. Somewhere deep in the thousands of pages of Dodd-Frank there is language intended to allow the FDIC to allow bank and BHC bondholders to lose money.

And now, in its inimitable and blundering way, the European Commission has just published its long-awaited bank resolution plan. Lo and behold, it calls for bondholders to lose money under certain circumstances. This is excellent timing, coming as it does in the middle of the greatest banking crisis in modern European history. At the very moment when Europe is moving heaven and earth to restore market confidence in its banks, the commission comes out with a plan to allow banks to default upon their bonds. This means that now potential buyers of bank obligations face the risk that, even in the event of a rescue, they will lose their investment.

Therefore, an analyst of European bank bonds (let’s say Spanish bank bonds), must analyze (1) the bank’s solvency; (2) the government’s solvency; (3) the likelihood that the government and/or its banks will be recapitalized by the EU in the event that the government is insolvent; and (4) the risk that in the event of a recapitalization, losses are imposed upon bondholders. (I might add that it has already been established that bank bondholders are subordinated to credits extended by the ECB and the IMF.) One must ask: would any thinking fiduciary consider adding such a security to his clients’ portfolios except as a pure speculation with commensurate yield?

How are such Spanish bank bonds trading today? Weaker names, such as Bankia, are trading as deep junk. Bankia is in the process of receiving EUR 19 billion in recapitalization funds from the state. Despite that, its bonds are trading at an implied Caa1, or at risk of default.

It appears that Europe has two desires: (1) to restore confidence in the eurozone banking systems; and (2) to ensure that weak banks in weak eurozone countries will never regain market access, and will thus become permanent wards of Europe. I am beginning to understand Mario Draghi’s frustration with his European “partners”.

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